When we talked on Wednesday, I answered the top ten questions you’ve been asking this year.
But I left something huge out…
It’s a technique you’ve been asking me almost every single week for the past month.
Now I left it out intentionally…
But I did so because we simply didn’t have the time to cover everything you need to know.
And quite frankly, it’s too important to your income to just skim over.
So today, I’ve devoted our entire conversation to this one question.
And it could save you a ton of money in May…
How to Use the Put Spread on Expensive Stocks to Capture Huge Gains in a Falling Market
As you know, and contrary to popular belief, options were created to minimize risk. You can use options to participate in a pending stock price move without having to spend tons of your money to do so. And you reduce your total risk because the price you’re paying for one contract (100 shares) is significantly less than what you would pay to buy one share of a stock.
To this day, they’re still being used for this purpose, but more and more savvy traders are now buying options with the primary intent profit from buying them at low prices and selling them at higher prices.
But as much as options are means to minimize risk, sometimes they can be deemed too expensive. On top of that, if you’re sitting on an option that needs the stock to move in one specific direction, then you face the risk of losing all of the money you spent if the stock doesn’t move in your favor.
As my proprietary tool, Money Calendar, shows, the month of May shows the bears leading the bulls. And the idea of making money in a bearish market could cause investors and some traders (especially those newer to options) some discomfort… Especially when both the stock and options on the stock seem just too expensive.
Now the question you’ve been asking me often is how you can exploit an expensive stock by trading options that also seem too expensive?
And today, we’re going to look at an extremely expensive stock and how you can make triple-digit profits for under $500 while cutting your risk in half.
We talked a bit about the put debit spread earlier this year (aka the bear put spread and the reverse loophole trade). But what I want to look at today is how you can use the bear put spread to make money on an expensive stock like The Priceline Group Inc. (NASDAQ: PCLN) while minimizing your total risk… and for no more than $500 of your hard-earned money.
How You Can Hedge Puts on PCLN
As of the time I’m writing this, PCLN is trading at $1,352 per share. The $1,350 put options on the stock, which are considered at-the-money for the month of May this year are trading for $51.90. This means that for one contract, you’d have to spend $5,190 ($51.90 x 100 shares).
We’ve talked before about risk management and why you should never risk more than 2% of your account on any one trade. Now you, your broker, chief financial planner, or financial advisor can decide the amount or percentage that you should risk…
…But buying a put option for $5,190 is a lot of a money to spend on one trade. Even if you’re saving yourself a ton of money by buying this put option over buying 100 shares of the stock – which would cost you $135,000 ($1,352 x 100 shares) – you’re still spending over ten times the maximum capital risk of 2%. And that could be pretty costly to you if the stock doesn’t move in your favor.
But this is what you can do…
Instead of spending that much money on one put option, you can simply sell another put option – with the same expiration with a lower strike price- at the same time.
This creates a put debit spread (or bear put spread). A put debit spread is created from buying-to-open one put option and selling-to-open another put option with the same month’s expiration. You would need to buy and sell the same number of contracts, and I recommend looking for a spread between the strike prices of about $5 to $10, depending on the stock and anticipated move. This means that you would want to sell the put option at a strike price that is between $5-$10 more than the strike price at which you bought the put option.
Buying-to-open the put option will cost you money (creating a debit in your account) while selling-to-open the put option with the lower strike price bring you money to offset the cost of the put you bought. The put option you bought is more expensive than the put option you sold, so you are still creating a debit to your account up front.
Keep in mind that you’re hedging your risk by creating a put debit spread. And the more you reduce your risk, the more you reduce your reward. But when you want the opportunity to double your money on an expensive stock like PCLN without spending $5,190 on one put option, this strategy sounds pretty good.
Let’s take a look at how a put debit spread will make you money – while saving you money at the same time…
In this example, we bought-to-open the
PCLN May 20, 2016, $1,350 put option while simultaneously selling-to-open the
PCLN May 20, 2016, $1,340 put option, creating a put debit spread. The difference in strike prices creates a $10-wide spread. Notice that both put options have the same expiration of May 20, 2016.
Now remember, the cost of buying one May 2016 $1,350 put option at $51.90 is $5,190… but by creating a put debit spread, you are only spending a total of $465. This is because you spent $51.90 on one put option while selling the other put option simultaneously for $47.25, giving you a difference of $4.65. One contract of 100 shares x the difference of $4.65 gives you your total cost of $465.
I’d much rather spend $465 for a put debit spread on a $1,352 stock than $5,190 for one put option or $135,200 for 100 shares of the stock… and I have a strong feeling you would, too.
Now the most you can lose on this trade is your total cost of $465. So no matter how far up the stock goes, you cannot lose more than that $465. You can consider closing the se the spread at expiration to be sure it all ends up as you like
Your Profit Potential Does Comes with Some Strings…
As I mentioned earlier, the smaller the risk, the smaller the reward. And the tradeoff for your maximum risk of $465 is that your maximum profit potential is capped, too.
In the put debit spread we looked at above, the most you can make is $535, which is realized if and when the stock is trades under the short leg of the spread – the $1340 put option.
If PCLN is trading under $1,340, you’d get the chance to exercise your right to sell the stock at $1,350 while buying the stock at $1,350 – resulting in that $10 hitting your account. That $10 credit to your account is offset by your original cost of $46, leaving you with a profit of $535. (Keep in mind that there may be commissions and fees, which could bring this number slightly lower).
Even though you could potentially make more going long a put, you would need to spend that $5,190 to do so – and the stock would need to move in your favor to avoid losing all of that money. In this situation, your maximum profits are capped at $535, but you only spent $465 on the trade and still earned a healthy 115% ($535/$465).
One last thing…
Before placing any spread trades, it’s very important that you check with your brokerage firm and make it clear that you want to trade spreads – both put and call spreads. You’ll need to have the right clearance to place spread trades as well as the right trading platform. OptionsXpress, Think or Swim (offered by TD Ameritrade), and Interactive Brokers are good ones, among others.
Here’s Your Trading Lesson Summary:
Options are a cheap and easy way to make money on expensive stocks like The Priceline Group Inc. (NASDAQ: PCLN). With options, you have the potential lock in higher gains while minimizing your risk. Sometimes, though, even options may seem too expensive – especially on stocks like PCLN. But you can double your money on expensive stocks like PCLN by creating spreads. Keep in mind that while your total risk is greatly reduced in a spread, your maximum profit potential is capped.
Have a wonderful weekend!
Good Trading,
Tom Gentile
P.S. Check out my new report… I’ll show you how you can double your money on the world’s most valuable companies. You can download it here.
